1. Financial Management I
Chap 03
Analysis of Financial Statements

2. Ratio Analysis
Financial statements report Both on a firm’s position at a point in time & on its operations over some past period.
Real Value of Financial Statements?
Usefulness of Financial Statement Analysis?
Ratio Analysis?

3. Ratio Analysis Liquidity Ratios Asset Management Ratios
Debt Management Ratios
Profitability Ratios
Market Value Ratios
DuPont Analysis

4. Liquidity Ratios
A liquid Asset is one that can be converted to cash quickly without having to reduce the Asset’s price very much.
Liquidity Ratios are ratios that show the relationship of a firm’s cash & other Current Assets to its liabilities.
Usefulness of Liquidity Ratios?
Most Commonly Used liquidity Ratios?

5. Liquidity Ratios – Current Ratio
Current Ratio indicates the extent to which Current Liabilities are covered by those Assets expected to be converted to cash in near future.
Current Ratio = Current Assets/Current Liabilities
Too High Ratio? Too low Ratio?
Increasing Trend? Decreasing Trend?

6. Current Ratio - Example
Cartwright Brothers has the following balance sheet (all numbers are expressed in millions of dollars):
Cash $ 250 Accounts payable $ 300
Accounts receivable 250 Notes payable 300
Inventories 250 Long-term debt 600
Net fixed assets 1,250 Common stock 800
Total assets $2,000 Total claims $2,000
Calculate Current Ratio:

7. Current Ratio - Example
Current Ratio = Cash + A/R +Inventory
A/P + N/P =
= 1.25

8. Current Ratio - Example
Iken Berry Farms has $5 million in current assets, $3 million in current liabilities, and its initial inventory level is $1 million. The company plans to increase its inventory, and it will raise additional short-term debt (that will show up as notes payable on the balance sheet) to purchase the inventory. Assume that the value of the remaining current assets will not change. The company’s bond covenants require it to maintain a current ratio that is greater than or equal to What is the maximum amount that the company can increase its inventory before it is restricted by these covenants?

9. Current Ratio - Example
Iken Berry Farms has $5 million in current assets, $3 million in current liabilities, and its initial inventory level is $1 million. The company plans to increase its inventory, and it will raise additional short-term debt (that will show up as notes payable on the balance sheet) to purchase the inventory. Assume that the value of the remaining current assets will not change. The company’s bond covenants require it to maintain a current ratio that is greater than or equal to What is the maximum amount that the company can increase its inventory before it is restricted by these covenants?
Iken Berry Farms has a current ratio of 1.67
If notes payable are going to be raised to buy inventories, both the numerator and the denominator of the ratio will increase causing Ratio to decrease.

10. Current Ratio - Example

11. Asset Management Ratios
Asset Management ratios is a set of ratios that measure how effectively a firm is managing its assets
Problem with having too many Assets? Or, too less Assets?
Most Commonly used Asset Management Ratios?

12. Asset Management Ratios
Asset Management ratios is a set of ratios that measure how effectively a firm is managing its assets
Problem with having too many Assets? Or, too less Assets?
Most Commonly used Asset Management Ratios:
Inventory Turnover ratio
Days Sales Outstanding
Fixed Asset Turnover Ratio
Total Asset Turnover Ratio

13. Asset Management Ratios – Inventory Turnover Ratio
Inventory Turnover is an approximation indicating how many times in a year, a company’s inventory is sold out or converted to sales.
Inventory T.O = Sales / Inventory
Too high Ratio? Too Low ratio?
Increasing Trend? Decreasing Trend?

14. Inventory Turnover Ratio - Example
XYZ’s balance sheet and income statement are given below:
Balance Sheet:
Cash $ Accounts payable $ 100
A/R Notes payable
Inventories 300 Long-term debt (10%)
Fixed assets Common equity
Total assets $1,000 Total liabilities & equity $1,000
Sales $1,000
Calculate Inventory Turnover Ratio? If Industry’s Inventory Turnover Ratio is 5, what would that imply for XYZ?

15. Inventory Turnover Ratio - Example
= 3.33

16. Asset management ratios – Days Sales outstanding
Days Sales outstanding (DSO), also called the collection period, indicates the average length of time the firm must wait after making a sale before it receives cash.
DSO = Receivables / Average Sales Per Day
= Receivables / (Annual Sales/ 365)
Should be compared with the terms on which the firm sells its goods!!

17. Days Sales outstanding - Example
Ruth Company currently has $1,000,000 in accounts receivable. Its days sales outstanding (DSO) is 50 days. The company wants to reduce its DSO to the industry average of 32 days by pressuring more of its customers to pay their bills on time. The company’s CFO estimates that if this policy is adopted the company’s average sales will fall by 10 percent. Assuming that the company adopts this change and succeeds in reducing its DSO to 32 days and does lose 10 percent of its sales, what will be the level of accounts receivable following the change? Assume a 365-day year.

18. Days Sales outstanding - Example
First, solve for current annual sales using the DSO equation as follows:
50 = $1,000,000/(Sales/365)
annual sales = $7,300,000
If sales fall by 10%,
The new sales level = $7,300,000(0.9) = $6,570,000.
Again, using the DSO equation, solve for the new accounts receivable figure as follows:
32 = AR/($6,570,000/365)
AR = $576,000.

19. Asset management ratios – Fixed Asset Turnover Ratio
The Fixed Asset Turnover ratio measures how effectively the firm uses its Plant & Equipment.
Fixed Asset T.O = Sales / Net Fixed Assets
Net Fixed Assets = Gross Fixed Assets – Accumulated Depreciation
Potential Problem with interpreting Fixed Asset T.O ratio?

20. Fixed Asset Turnover Ratio - Example
Your company had the following balance sheet and Sales of $10,000 for 2002:
Balance Sheet:
Cash $ 20
A/R 1,000
Inventories 5,000
Total current assets $6,020 Debt $4,000
Net fixed assets 2,980 Equity 5,000
Total assets $9,000 Total claims $9,000
If Company wants to increase its sales by 10% & maintain a Fixed Asset Turnover Ratio of 4.45, what would should be the level of Net Fixed Assets. Also, calculate increase or Decrease in Net Fixed Assets.

21. Fixed Asset Turnover Ratio - Example
New Level of Sales = 10,000 (1.10) = 11,000
Fixed Asset T.O = 4.45
Solve for New Level of Fixed assets:
= 11,000 / X
X = 11,000 / 4.45
= 2472
Decrease in Fixed Assets = 2980 – 2472
= 508

22. Asset management ratios – Total Asset Turnover Ratio
The Total Asset Turnover Ratio measures the turnover of all the firm’s Assets.
Total Asset T.O = Sales / Total Assets

23. Asset Management Ratios - Example
Taft Technologies has the following relationships:
Annual sales $1,200,000.00
Current liabilities $ 375,000.00
Days sales outstanding (DSO)
Inventory turnover ratio
Current ratio
The company’s current assets consist of cash, inventories, and accounts receivable. How much cash does Taft have on its balance sheet?

24. Asset Management Ratios - Example
First, find the amount of current assets:
Current ratio = Current assets/Current liabilities
Current assets = (Current liabilities)(Current ratio)
= $375,000(1.2) = $450,000.
Next, find the accounts receivables:
DSO = AR/(Sales/365)
AR = DSO(Sales)(1/365)= (40)($1,200,000)(1/365) =$131,
Next, find the inventories:
Inventory turnover = Sales/Inventory
Inventory = $1,200,000/4.8 =$250,000.
Finally, find the amount of cash:
Cash = Current assets - AR - Inventory
= $450,000 - $131, $250,000
= $68,  $68,493.

25. Debt Management Ratios
The extent to which a firm has debt financing or Financial Leverage, has three important implications:
By raising funds through debt, stockholders can maintain the control of the firm while limiting their investments
Creditors look at the equity as owner supplied funds , to provide a margin of safety.
If the firm earns more on investments financed with borrowed funds than it pays in interest, the return on owner’s capital is magnified.

26. THE Effects of Financial Leverage - Example
We consider case of company X which has no debt & is considering restructuring to include debt in its capital structure.
We look at DEBT & NO DEBT situations
Taxes are ignored 2

27. THE Effects of Financial Leverage - Example
Current
Proposed
Assets
$8,000,000
Debt
4,000,000
Equity
8,000,000
Debt-Equity Ratio 1
Share Price 20
# of Shares
400,000
200,000
Interest Rate
10%

28. THE Effects of Financial Leverage - Example
Current Capital Structure: No Debt
Recession
Normal
Expansion
EBIT
$500,000
$1,000,000
$1,500,000
Interest
Net Income
500,000
1,000,000
1,500,000
ROE
6.25%
12.5%
18.75%
EPS
1.25
2.50
3.75

29. THE Effects of Financial Leverage - Example
Proposed Capital Structure: Debt - $4 Million
Recession
Normal
Expansion
EBIT
$500,000
$1,000,000
$1,500,000
Interest
400,000
Net Income
100,000
600,000
1,100,000
ROE
2.50%
15.50%
27.50%
EPS
0.50
3.00
5.50

30. Debt Management Ratios – Debt Ratio
The Debt Ratio measures the percentage of funds provided by creditors. Total Debt includes both Current Liabilities & Long Term Debt.
Debt Ratio = Total Debt / Total Assets
Creditors prefer low Debt ratio because the lower the ratio, the greater the cushion against Creditor’s losses in the event of liquidation.
What about Stockholders?

31. Debt Ratio - Example
Kansas Office Supply had $24,000,000 in sales last year. The company’s net income was $400,000, its total assets turnover was 6.0, and the company’s ROE was 15 percent. The company is financed entirely with debt and common equity. What is the company’s debt ratio?

32. Debt Ratio - Example Sales/Total assets = 6
= $4,000,000.
ROE = NI/Equity
Equity = NI/ROE
= $400,000/0.15
= $2,666,667.
Debt = Total assets - Equity
= $4,000,000 - $2,666,667
= $1,333,333.
Debt ratio = $1,333,333/$4,000,000 =

33. Debt Management Ratios – Times Interest Earned Ratio
Times Interest Earned Ratio is a measure of the firm’s ability to meet its annual interest payments.
TIE = EBIT / Interest Charges
Point to Note:
Earnings before interest & taxes, rather than Net income is used in the numerator because interest is paid with pre-tax dollars, the firm’s ability to pay current interest is not effected by taxes.

34. Times Interest Earned Ratio - Example
Culver Inc. has earnings after interest but before taxes of $300. The company’s times interest earned ratio is Calculate the company’s interest charges.

35. Times Interest Earned Ratio - Example
Culver Inc. has earnings after interest but before taxes of $300. The company’s times interest earned ratio is Calculate the company’s interest charges.
TIE = EBIT/INT
7 = ($300 + INT)/INT
7INT = $300 + INT
6INT = $300
INT = $50.

36. Times Interest Earned Ratio – Disadvantages
Interest is not the only financial charge- companies must also pay back principle & many firms lease assets & must make lease payments.
EBIT does not reflect all the cash flows available to service debt, especially if a firm has high depreciation and/or amortization charges.

37. Debt Management Ratios – EBITDA Coverage Ratio
The EBITDA coverage ratio is most useful for relatively short term lenders as over a relatively short period, depreciation generated funds can be used to service debt.
EBITDA Coverage Ratio:
EBITDA + lease Payments
Interest +Principal Payment +Lease Payments

38. Profitability Ratios
Profitability ratios include a group of ratios that show the combined effect of liquidity, asset management & debt on operating results.
Profitability ratios constitute of:
Profit Margin on Sales
Basic Earning Power (BEP)
Return on Total Assets (ROA)
Return on Common Equity (ROE)

39. Profitability Ratios – Profit Margin on Sales
Profit Margin Ratio measures Net Income per dollar of Sales.
Profit Margin on Sales = Net Income / Sales
Special Case of Financial Leverage!!

40. Profitability Ratios - Basic Earning Power
The BEP ratio indicates the ability of the firm’s Assets to generate operating Income.
BEP = EBIT / Total Assets
This ratio shows the raw earning power of the firm’s Assets, before the influence of taxes & leverage, and it is useful for comparing firms with different tax situations & different degrees of financial leverage.

41. BEP - Example
Peterson Packaging Corp. has $9 billion in total assets. The company’s basic earning power (BEP) ratio is 9 percent, and its times interest earned ratio is Peterson’s depreciation and amortization expense totals $1 billion. It has $0.6 billion in lease payments and $0.3 billion must go towards principal payments on outstanding loans and long-term debt. What is Peterson’s EBITDA coverage ratio?

42. BEP - Example EBIT = $810,000,000. 3 = EBIT/INT 3 = $810,000,000/INT
EBITDA = EBIT + DA
= $810,000,000 + $1,000,000,000
= $1,810,000,000.
EBITDA coverage ratio = ( )/( ) =  2.06.

43. Profitability Ratios – Return on Total Assets
The ratio of Net Income to total Assets measures the return on total Assets (ROA) after interest & taxes.
ROA = Net Income / Total Assets

44. ROA - Example
Aaron Aviation recently reported the following information:
Net income $500,000
ROA 10%
Interest expense $200,000
The company’s average tax rate is 40 percent. What is the company’s basic earning power (BEP)?

45. ROA - Example
Given ROA = 10% and net income of $500,000, total assets must be $5,000,000.
To calculate BEP, we still need EBIT. To calculate EBIT construct a partial income statement:
EBIT $1,033,333 ($200,000 + $833,333)
Interest ,000 (Given)
EBT $ 833,333 ($500,000/0.6)
Taxes (40%) ,333
NI $ 500,000
BEP = EBIT /TA = 1033,333 / 5,000,000
= or 20.67%.

46. Profitability Ratios – Return on Common Equity
The Return on Common Equity Ratio measures the Return on Common Stockholders’ investments.
ROE = Net Income / Common Equity

47. Return on Common Equity - Example
Tapley Dental Supply Company has the following data:
Net income $240
Sales $10,000
Total assets $6,000
Debt ratio %
TIE ratio
Current ratio
BEP ratio %
If Tapley could streamline operations, cut operating costs, and raise net income to $300 without affecting sales or the balance sheet (the additional profits will be paid out as dividends), by how much would its ROE increase?

48. Return on Common Equity - Example
= $1,500.
Current ROE = 240/1500
= 16%.
New ROE =300/1500
= 0.20 or 20%.
ROE = 20% - 16%
= 4%.

49. Financial Management I
Chap 03
Analysis of Financial Statements

50. Ratio Analysis Liquidity Ratios Asset Management Ratios
Debt Management Ratios
Profitability Ratios
Market Value Ratios
DuPont Analysis

51. Market Value Ratios
Market Value Ratios constitute set of ratios that relate the firm’s stock price to its earnings, cash flows & book value per share:
Price/ Earning Ratio
Price/ Cash flow ratio
Market/Book Value Ratio

52. Market Value Ratios – Price/Earnings Ratio
The ratio of Price per Share to earnings per share shows the dollar amount investors will pay for $1 of current earnings.
P/E Ratio = Price Per Share / Earnings Per Share
Purpose?

53. Price/Earnings Ratio - Example
Cleveland Corporation has 100,000 shares of common stock outstanding, its net income is $750,000, and its P/E is 8. What is the company’s stock price?

54. Price/Earnings Ratio - Example
Cleveland Corporation has 100,000 shares of common stock outstanding, its net income is $750,000, and its P/E is 8. What is the company’s stock price?
EPS = $750,000/100,000 = $7.50.
P/E = Price/EPS = 8.
Thus,
Price = 8  $7.50 = $60.00.

55. Market Value Ratios/ Price/Cash flow Ratio
The ratio of Price per Share to cash flow per share shows the dollar amount investors will pay for $1 of cash flows.
P/CF Ratio = Price Per Share / Cash Flow Per Share
Where:
CF = (NI + Non Cash Charges)
Purpose?

56. Market Value Ratios - Market/Book Value Ratio
The ratio of stock’s Market price to its book value gives another indication of how investors regard the company.
Companies with relatively high rates of return on Equity generally sell at higher multiples of book Value than those with low Returns.
Market/Book Ratio = Market Price per share
Book Value per Share

57. Market/Book Value Ratio - Example
Strack Houseware Supplies Inc. has $2 billion in total assets. The other side of its balance sheet consists of $0.2 billion in current liabilities, $0.6 billion in long-term debt, and $1.2 billion in common equity. The company has 300 million shares of common stock outstanding, and its stock price is $20 per share. What is Strack’s market/book ratio?

58. Market/Book Value Ratio - Example
TA = $2,000,000,000; CL = $200,000,000;
LT debt = $600,000,000; CE = $1,200,000,000;
Shares outstanding = 300,000,000; P0 = $20;
M/B = ?
Book value = 1200 Million / 300 Million
= $4.00.
M/B = 20/4
= 5.0.

59. The DuPont Equation
The DuPont Equation is the formula which shows that the rate of return on Assets can be found as the product of the profit Margin times the total Asset Turnover.
Thus,
ROA = Profit Margin * Total Asset Turnover
= (NI/Sales) * (Sales/Total Assets)

60. The Extended DuPont Equation
ROA = Net Income / Total Assets
ROE = Net Income/Total Equity
Equity Multiplier = Total Assets/Common Equity

61. The Extended DuPont Equation
ROA = Net Income / Total Assets
ROE =Net Income/Total Equity
Equity Multiplier = Total Assets/Common Equity
Thus,
ROE = Profit Margin * TATO * Equity Multiplier
= (NI/Sales) * (Sales/TA) * (TA/Equity)

62. The Extended DuPont Equation - Example
Company A has sales of $1,000, assets of $500, a debt ratio of 30 percent, and an ROE of 15 percent. Company B has the same sales, assets, and net income as Company A, but its ROE is 30 percent. What is B’s debt ratio? (Hint: Begin by looking at the Du Pont equation.)

63. The Extended DuPont Equation - Example
ROE = (NI/Sales) * (Sales/TA) * (TA/Equity)
0.15 = (NI/1000) * (1000/500) * (500/0.7*500)
Thus,
NI = 52.50
Therefore,
NPM (B) = 52.5/1000
= 5.25%

64. The Extended DuPont Equation - Example
Data for Co. B:
ROE = (NI/Sales) * (Sales/TA) * (TA/Equity)
0.30 = * 2 * ( TA / Equity)
0.30 = * (500 /Equity)
Hence,
Equity = $175
Debt = 500 – 175
= 325
Therefore,
Debt Ratio = 325 /500
= 65 %

65. Limitations of Ratio Analysis
Multiple Divisions in different Industries
Average Not Enough for Most firms
Inflation
Seasonal Factors
Window Dressing Techniques
Different Accounting Practices
Difficult to generalize

66. Thank you for your Time & Patience 